Why hiking Vat will be very painful

Allister Heath
SO George Osborne has got his office for budget responsibility, tasked with auditing the public finances and producing independent economic forecasts. It is a splendid idea and a great opportunity for Sir Alan Budd, its first boss, to create a set of truly transparent national accounts. A crucial test will come with the treatment of Britain’s monstrous off-balance sheet liabilities: private finance initiative (PFI) payments due over the next 25 years have jumped from £60.5bn in 2000 (6.3 per cent of GDP) to 206.8bn (14.4 per cent of GDP) in the 2010 Budget. These are excluded from the official public debt. Government contracts such as IT projects and defence procurement should also be included, as well as pension obligations for public sector workers and the future cost of nuclear decommissioning. To publish proper, realistic accounts would be a revolutionary change from the Brown years, which had become synonymous with opacity, deliberate obfuscation and fiddled statistics.

Ideally, the new government would entirely eschew tax rises and the entirety of the deficit reduction would come from lower spending, combined with a plan for faster growth based around supply-side reforms and the liberation of Britain’s entrepreneurial talents. Sadly, we know that this is not to be; even higher taxes are on the way. It is essential that further increase in marginal tax rates on income or capital – such as the regrettable and destructive decision on capital gains tax – are avoided, so the only other avenue is higher value added tax. This would be less damaging to the economy’s efficiency than any of the other increases Osborne could unveil at his emergency budget on 22 June.

But with a budget deficit of £163bn in 2009-10 and a structural shortfall – which Budd will tell us is even larger than we all feared – putting up the headline rate of VAT from 17.5 per cent to 20 per cent could merely be the start. It will raise just £12.5bn-£13bn, according to an analysis by Michael Saunders of Citigroup. Osborne may choose to go further, especially if he wants to remove lots of low earners from income tax.

Increasing the reduced rate from 5 per cent to 7.5 per cent would bring in £750m. Hiking the rate on fuel from 5 per cent to 17.5 or even 20 per cent would bring in £4bn. The only way to raise truly serious money would be to abolish entirely the zero rate currently charged on food, children’s clothing and new homes. Extending the 5 per cent reduced rate to all these items would yield £8bn per year; the full 17.5 per cent rate would raise £27bn per year (and over £30bn at 20 per cent).

To clarify: I don’t support any of these moves, all of which would deal devastating blows to millions of people. I would rather see no tax hikes at all – but these are the sorts of calculations that will be taking place at the Treasury over the next few weeks. Hiking VAT on zero or low-rated goods would necessitate a substantial hike in benefits to cushion the blow on the poor, with implications for incentives to work; the net revenue raised from each of these measures would therefore be less than the totals above. It would be a deeply unpleasant solution– but unless Osborne is prepared to push through truly radical cuts in public spending, including Spanish style state sector wage cuts, he will find his options to be terribly restricted. Reality is about to hit the great British public – and it will hurt.